The flaws with the most widely used approach to investing

Standard asset allocation practice (“strategic asset allocation”) is commonly used across the financial services industry as the investing approach for investing.

Strategic asset allocation is based on modern portfolio theory. Modern portfolio theory is derived from a research paper written by Harry Markowitz. In his paper, Markowitz describes two stages to investing portfolio construction:

“The first stage starts with observation and experience and ends with beliefs about the future performances of available securities. The second stage starts with the relevant beliefs about future performances and ends with the choice of the portfolio. This paper is concerned with the second stage.”

Unfortunately the standard practice in the strategic asset approach assumes investment performance over the last 100+ years will be the same on average In the next 100+ years.

But research shows that investing is like life it’s complicated…..for example…analysis shows investing in stocks works best in time frames typically of 7-10 years.

AND, most importantly research also shows you have to be able to make adjustments to your investing approach in order to achieve above average performance.

Why, because history shows that over 10 year holding periods the returns on stocks can vary significantly when you factor in valuation. This chart illustrates the point.

Also research illustrates that different investment types or asset classes ( stocks, bonds, commodities) can fall together in a financial crisis and do not collectively provide safety for a strategic asset allocation strategy.

“One of the most vexing problems in investment management is that diversification seems to disappear when investors need it the most. We surmise that many investors still do not fully appreciate the impact of extreme correlations on portfolio efficiency—in particular, on exposure to loss. “

When Diversification Fails

Here is the paper to read:

So, what’s the main problem with strategic asset allocation? When losses grow, the gain required to make up the loss grows exponentially…as illustrated in this chart.